Wells Fargo & Co (WFC) Nomads Should Follow Buffett’s Lead

The drop in Wells Fargo share price is too severe given its overall reputation

Wells Fargo & Co (NYSE:WFC)has been embroiled in a scandal for nearly a month now since news broke that thousands of Wells Fargo employees fraudulently opened more than 2 million bank and credit card accounts for its customers without their consent. I am, however, comforted by Warren Buffett’s $100 million personal stake in the bank, as well as Berkshire Hathaway Inc.‘s (NYSE:BRK.A, NYSE:BRK.B) near-10% stake.

WFC stock is down 11% since the Consumer Financial Protection Bureau and other agencies fined Wells Fargo in the amount of $185 million for the misconduct, which appears to have occurred steadily between 2011 and 2015.

We also learned that Wells fired more than 5,000 frontline employees connected to what is widely being described as the latest banking scandal to dupe Main Street savers.

The news hasn’t improved much since — CEO and Chairman John Stumpf has been dragged in front of Congressional members for what has amounted to a couple of severe public scoldings, and politicians in California and Illinois are succeeding in restricting the giant bank’s ability to work on public deals and actively ban its other business in their states. More states are likely to follow suit.

There is little question that the scandal has bruised Wells Fargo’s reputation. It will continue to lose business because of the loss of trust and not handling the damage control well. Stumpf’s public responses have lacked much remorse or an apologetic tone, and the public is up in arms that daily employees were fired but upper management has largely gone unpunished, save for Stumpf losing some $41 million in stock awards.

In an ironic twist, WFC still has one of the best reputations among the large banks. It has staked its reputation on serving Main Street savers and has largely eschewed the investment banking activities that caused many of its peers to effectively fail during the financial crisis — namely Lehman Brothers, Bear Stearns and Merrill Lynch. It rescued Wachovia during the crisis and extended its banking reach to the eastern part of the country and avoided the demise that rivals including Wachovia and Washington Mutual experienced.

And honestly, the $185 million fine isn’t that significant to Wells. The bank boasted total shareholders’ equity to nearly $193 billion, or approximately $33.81 per share at the end of last year. Management’s argument that the matter was immaterial and not necessary to disclose back in 2011 is certainly a valid one.

JPMorgan Chase & Co.’s (NYSE:JPM) “London Whale” trading loss of $6.2 billion was much larger, and actually still not that big given its book value of around $250 billion. The allegations against German-based banking giant Deutsche Bank AG (USA) (NYSE:DB) handling of mortgages during the crisis will likely end up costing it around $5 billion.

The fact the fine wasn’t larger also suggests that regulators didn’t consider it an egregious act against customers. It is already reevaluating a business focus that incentivizes the cross-selling of products. Clearly, certain employees were feeling pressured to make sales goals and wrongly chose to cheat the system to make their numbers.

Investment Appeal of Wells Fargo

The fundamentals also support a bull case for Wells Fargo, especially given the recent stock drop. The bank’s return on equity, one of the best indicators of how well a bank is managed, is around 12%. This beats most of its peers, save U.S. Bancorp (NYSE:USB), a large regional bank. U.S. Bank’s ROE ended last year close to 14%, which is downright impressive.

JPMorgan, which currently has the best reputation among large banks, reported an ROE right at 10% to close out 2015, which is still respectable. Bank of America Corp (NYSE:BAC) and Citigroup sport rather dismal ROE levels only in the mid-single digits. They are also stuck with severely tarnished reputations in today’s post-crisis banking environment.

My best guess is that Wells Fargo loses some business as a result of this scandal, but doesn’t see a meaningful or sustainable decline in its sales or profits. ROE levels should easily stay in the double-digits, but it will take some time for its reputation to return to previous highs.

Berkshire Hathaway, which owns roughly 10% of Wells Fargo, earlier this year applied to boost its stake above 10%. That, however, requires a review and approval by regulators, and was obviously before the scandal broke.

Buffett is well known for avoiding people and companies with dubious business ethics. He certainly isn’t perfect in having done so, but his relationship with Wells Fargo goes back decades.

It is unlikely that his opinion of the bank has worsened significantly, although we won’t know until filings become public of his stock buys or sells for the third quarter.

The Bottom Line on Wells Fargo

Buffett, who reportedly has a close relationship with JPMorgan CEO Jamie Dimon, backed Dimon during the “London Whale” trading fiasco. He remarked at the time that “if a cop follows you for 500 miles, you’re going to get a ticket,” to imply that the regulatory environment for banks is undeniably hostile these days.

The bottom line is that Wells’ predicament is unfortunate and completely its own doing. But it still has a solid overall reputation and has among the best financial profiles in the banking industry.

The scandal is also arguably a blessing in disguise where Wells will be on even better behavior going forward considering that its golden-child sheen has dulled.

Wells Fargo stock appears a solid buy below $50 per share. In the meantime, investors can earn a 3.4% dividend yield ($1.50 per share annually) that is well supported by earnings of around $4 per share.

There is also plenty of capacity for management to boost its payout going forward, though likely not until the scandal starts to pass in the public’s mind.

As of this writing, Ryan Fuhrmann did not hold a position in any of the aforementioned securities.